August 2018: Monthly Insights & Economic Dashboard

AllegiantPA Economic Dashboard Portrait August 2018 webFor months I’ve written about the strengthening U.S. economy. More evidence of such came in the 2nd quarter GDP report, which showed the U.S. economy grew at a robust 4.1%. There were some one-time fluctuations in the number, but after canceling out the one-time effects, growth was still quite good (read our recent Feature about the GDP report to find out more). Even more impressive, on July 27th the Bureau of Economic Analysis released their once every five-year comprehensive update and it showed years of economic data were actually better than originally thought. One of the changes was a 2% per year increase in the national savings rate over the past five years (click here to read more). Trade remains the major economic concern and it will remain front and center until we have some resolutions. As there has been little further development on trade, this month I will focus on the markets.

U.S. equity markets have so far pieced together quite a good 2018, even with increased economic uncertainly and market volatility. As of the end of July, the S&P 500 was up 6.5%, not bad for seven months of the year. However, this number may be misleading. As I’ve written numerous times, breaking down data different ways provides greater insight. The devil is always in the details. For example, understanding where the returns came from - what did well and what did poorly - tells us more about the health of the markets.

Markets are commonly divided between value stocks (companies trading at less expensive valuation metrics with slower growth profiles) and growth stocks (companies trading at more expensive valuations based on hopes for future growth potential). Dividing the market this way shows growth stocks have drastically outperformed value stocks so far in 2018, 11% versus 2%. Additionally, many value stocks that are also dividend-paying stocks performed even worse as interest rates moved higher. Investors are increasingly investing in companies hoping for future growth. This is not unusual in the later stages of an economic cycle. But, it also means many investors may not be aware of the risk they are taking when the economy turns, or future growth does not materialize.

Looking at market breadth, which describes what percentage of companies are participating in the broad market move, the data is not great, although it has improved markedly the last couple of months. Nearly 40% of S&P 500 stocks have negative returns so far in 2018. The market averages are being lifted by only a handful of stocks, more specifically the headline grabbing FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google). By mid-year, tech stocks accounted for all of the S&P 500’s return.

Expanding our data further, while the S&P 500 is having a good year, foreign markets are not. Developed countries (ex-USA) are down 0.5% for the year, while emerging market stocks are down nearly 4.5%. Even bonds are down so far this year.

Paul Cantor, our COO, recently wrote a white paper entitled “The Fallacy of Average,” which among other things details the phenomenon of investment returns in 2018. It is certainly worth the read as it eloquently breaks down common data in a very thought-provoking way. The technology sector’s recent outperformance is significant, but it does not appear to be another tech bubble like the late 90s. Most of the dominant tech companies today have real revenue, actual earnings, and user bases larger than the population of many countries. However, a rotation from tech to other underperforming sectors would not be a surprise. Even with markets moving higher, many companies are trading at valuations much lower than what they were a few years ago.

Solid companies in growing businesses give very good results over time, although not on a year-in, year-out basis. The time to buy is when they are out of favor and the time to sell is when expectations can’t go any higher. In the future, as we look back on 2018, I wouldn’t at all be surprised to find expectations approaching peak levels. This doesn’t mean bad times are right around the corner, but it does mean we need to begin preparing for when the data and expectations reverse. In the meantime, the U.S. markets and economy are riding high.

If you would like to see more data and charts about the economy and various financial markets, please see our Monthly Insights book.

Benjamin W. Jones, CFP®, AIF®
Chief Investment Officer, Principal